Real estate investment is all about building wealth. Private equity real estate fund managers look for well-positioned assets that they can make more valuable and then sell. Commercial real estate investors also have a keen interest in how long it will take for these properties to appreciate.
Firms often cite two metrics to describe their assets’ return on investment: the internal rate of return, or “IRR,” and the equity “multiple.”
While both the IRR and multiple analyze cash flow, the IRR describes the compounded annual percentage rate every dollar earns during the period it is invested.
This number also accounts for the time value of money — the idea that a dollar you have today is worth more than a dollar you have in the future, and the longer it takes to realize future earnings, the less valuable it becomes. We can forecast an expected IRR, or use actual results to calculate a realized IRR.
Many private equity real estate investors focus on IRR as a type of interest rate, something investors can use to compare real estate investment returns to profits from stocks or other equity investments. IRR is time-dependent, so a project that delivers $1 million over 5 years will have a higher IRR than a project that nets $1 million over 10 years.
But IRR doesn’t tell the whole story. If a $1 million investment lasts only a month and pays $50,000, its IRR is 70 percent. That’s an impressive short-term gain, but it doesn’t get very far toward building that $1 million into more substantial wealth. In this example, the multiple on equity is only 1.05x.
The equity multiple reflects the amount of money an investor gets back by the end of a deal. If a commercial real estate investor puts $1 million into a property and eventually gets back $2 million, the multiple is 2x.
Knowing the multiple on equity shows an investment’s true impact on wealth. Over five years, it takes just a 15 percent IRR on $1 million to build the sum to $2 million.
Private equity real estate investors can find many impressive IRRs out there on short-term deals. But pay attention to the time period it took to achieve that. A 30 percent IRR over three months works out to a total return of only 7.5 percent. That’s a lot of effort and expense, with not a lot to show for it. It’s manufactured wealth. Multiples are the product of real wealth.
Real estate is not a liquid investment. Its true potential and return on investment is not in short-term profits, but in long-term capital gains. Investors should understand IRRs and multiples as ways that properties create profit. That’s how they can build the kind of wealth that can change lives.